Summary

The April 2017 Global Financial Stability Report (GFSR) finds that financial stability has continued to improve since last October. Economic activity has gained momentum and longer-term interest rates have risen, helping to boost the earnings of banks and insurance companies. Despite these improvements, however, threats to financial stability are emerging from elevated political and policy uncertainty around the globe. If policy developments in advanced economies make the path for growth and debt less benign than expected, risk premiums and volatility could rise sharply. In addition, a shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment. Getting the policy mix right is crucial. In the United States, policymakers should provide incentives for economic risk taking while guarding against excessive financial risk taking. Emerging market economies should address domestic imbalances to enhance their resilience to external shocks. In Europe, domestic banking systems continue to face significant structural challenges. Furthermore, there should be no rollback of the postcrisis reforms that have strengthened oversight of the financial system. The April 2017 GFSR also includes a chapter that examines how a prolonged low-growth, low-interest rate environment can fundamentally change the nature of financial intermediation. In such an environment, yield curves would likely flatten. Combined with low credit demand, this would lower bank earnings, particularly for smaller, deposit-funded, and less diversified institutions, and presenting long-lasting challenges for life insurers and defined-benefit pension funds. Another chapter assesses the ability of country authorities to influence domestic financial conditions in a financially integrated world. It finds that, despite the significant impact on domestic financial conditions of global shocks, countries retain influence to achieve domestic objectives—specifically, through monetary policy.

Front Matter

Chapter 1
: Getting the Policy Mix Right

Chapter 1 finds that financial stability has continued to improve since the October 2016 Global Financial Stability Report. Economic activity has gained momentum and longer-term interest rates have risen, helping to boost earnings of banks and insurance companies and improving appetite for risk. Despite this improvement, new threats to financial stability are emerging from elevated political and policy uncertainty around the globe. If policy developments in advanced economies mean a less benign path for growth and debt than expected, risk premiums and volatility could rise sharply, undermining financial stability. In addition, a shift toward protectionism in advanced economies could reduce global growth and trade, impede capital flows, and dampen market sentiment. Getting the policy mix right is crucial. In the United States, policymakers should provide incentives for economic risk taking, while guarding against excessive financial risk taking that could undermine financial stability. Emerging market economies should address domestic imbalances while protecting themselves from external shocks. In Europe, banking systems face structural challenges that need to be tackled. The postcrisis reform agenda has strengthened oversight of the financial system, raised capital and liquidity buffers of individual institutions, and improved cooperation among regulators. Caution is needed when considering any rollback of this progress.

Chapter 2 analyzes the potential long-term impact of a scenario of sustained low growth and low real and nominal rates for the business models of financial institutions and the products offered by the financial sector. Advanced economies have experienced low interest rates and growth since the global financial crisis. Despite recent signs of an increase in longer-term yields, an imminent exit from low rates is not guaranteed, given the prevalence of slow-moving structural factors, such as demographic aging and stagnation in productivity growth. The confluence of these factors could change the nature of financial intermediation. Credit demand would likely be lower whereas household demand for transaction services would likely rise. Consequently, banking in advanced economies may evolve toward fee-based services. Aging will increase demand for health and long-term-care insurance, and low asset returns would accelerate the transition to defined-contribution private pension plans. Demand is likely to weaken for long-term savings products offered by insurers in favor of passive index funds. Policies could help ease the adjustment to such an environment by providing incentives to ensure longer-term stability instead of merely attenuating short-term pain.

Chapter 3 examines whether countries still retain influence over their domestic financial conditions in a globally integrated financial system. The chapter develops financial conditions indices that make it possible to compare a large set of advanced and emerging market economies. It finds that global financial conditions account for 20 to 40 percent of the variation in countries’ domestic financial conditions, with notable difference among economies. The importance of this global factor does not, however, seem to have increased much over the past two decades. Despite the significant role of global financial shocks, countries seem to be able to influence their own financial conditions to achieve domestic objectives—specifically, through monetary policy. But because domestic financial conditions react strongly and rapidly to global financial shocks, countries may find it difficult to implement timely policy responses. Emerging market economies, which are more sensitive to global financial conditions, should prepare for tighter external financial conditions. Governments can promote domestic financial deepening to enhance resilience to global financial shocks. In particular, developing a local investor base, as well as fostering greater equity- and bond-market depth and liquidity, can help dampen the impact of such shocks.